Some important terms, Beta of Investment

1. Risk Premium:
A risk premium is the return in excess of the risk-free rate of return an investment is expected to yield; an asset's risk premium is a form of compensation for investors who tolerate the extra risk, compared to that of a risk-free asset, in a given investment.
For example, a fixed deposit in reputed bank like SBI is giving you a return of 10% and it’s totally risk free or vey minimum risk. On the other hand when you invest in fixed deposit with a local bank which is not reputed then you will get a return of 15%. But at the same time the return from local bank is not guaranteed local bank might fail and you might not get anything. So here you are taking a risk to get a return of 15% which is more than fixed return of 10%. The extra return of 5% which you might get is called Risk Premium.

2. Risk Return Trade off:
The risk-return tradeoff is the principle that potential return rises with an increase in risk. Low levels of uncertainty or risk are associated with low potential returns, whereas high levels of uncertainty or risk are associated with high potential returns. According to the risk-return tradeoff, invested money can render higher profits only if the investor is willing to accept the possibility of losses.
The appropriate risk-return tradeoff depends on a variety of factors including risk tolerance, years to retirement and time of investment. For example, the ability to invest in equities over the long-term provides the potential to recover from the risks of bear markets and participate in bull markets, while a short time frame makes equities a higher risk proposition.

Beta of an Investment or an Asset
In finance, the beta (β or beta coefficient) of an investment indicates whether the investment is more or less volatile than the market. In general, a beta less than 1 indicates that the investment is less volatile than the market, while a beta more than 1 indicates that the investment is more volatile than the market.
A beta below 1 can indicate two things
1. If beta is between 0 and 1 then the investment is less volatile than the market. An example of the first is a treasury bill: the price does not go up or down a lot even when the market moves, so it has a low beta
2. If beta is less than 0 i.e. Negative Beta then it means volatile investment whose price movements are not correlated with the market. A negative beta correlation would mean an investment that moves in the opposite direction from the stock market. When the market rises, then a negative-beta investment generally falls. When the market falls, then the negative-beta investment will tend to rise. This is generally true of gold stocks and gold bullion.

CAPM Model
CAPM stands for Capital Asset Pricing Model

Whenever an investment is made, for example in the shares of a company listed on a stock market,
there is a risk that the actual return on the investment will be different from the expected return.
Investors take the risk of an investment into account when deciding on the return they wish to receive
for making the investment. The CAPM is a method of calculating the return required on an investment,
based on an assessment of its risk.
SYSTEMATIC AND UNSYSTEMATIC RISK
If an investor has a portfolio of investments in the shares of a number of different companies, it might
be thought that the risk of the portfolio would be the average of the risks of the individual investments.
In fact, it has been found that the risk of the portfolio is less than the average of the risks of the
individual investments. By diversifying investments in a portfolio, therefore, an investor can reduce the
overall level of risk faced.
There is a limit to this risk reduction effect, however, so that even a ‘fully diversified’ portfolio will not
eliminate risk entirely. The risk which cannot be eliminated by portfolio diversification is called
‘undiversifiable risk’ or ‘systematic risk’, since it is the risk that is associated with the financial system.
The risk which can be eliminated by portfolio diversification is called ‘diversifiable risk’, ‘unsystematic
risk’, or ‘specific risk’, since it is the risk that is associated with individual companies and the shares they
have issued.

THE CAPITAL ASSET PRICING MODEL
The CAPM assumes that investors hold fully diversified portfolios. This means that investors are assumed by the CAPM to want a return on an investment based on its systematic risk alone, rather than on its total risk. The measure of risk used in the CAPM, which is called ‘beta’, is therefore a measure of systematic risk.
The formula for the CAPM is as follows:
E (ri) = Rf + βi (E (rm) – Rf)
E (ri) = return required on financial asset i
Rf = risk-free rate of return
βi = beta value for financial asset i
E (rm) = average return on the capital market
This formula expresses the required return on a financial asset as the sum of the risk-free rate of return and a risk premium: βi (E (rm) - Rf) – which compensates the investor for the systematic risk of the financial asset.

THE RISK-FREE RATE OF RETURN
In the real world, there is no such thing as a risk-free asset. Short-term government debt is a relatively safe investment, however, and in practice, it can be used as an acceptable substitute for the risk-free asset.
In order to have consistency of data, the yield on treasury bills is used as a substitute for the risk-free rate of return when applying the CAPM to assets that are traded on the capital market. Note that it is the yield on treasury bills which is used here, rather than the interest rate.

THE RISK PREMIUM
Rather than finding the average return on the capital market, E (rm), research has concentrated on finding an appropriate value for (E (rm) - Rf), which is the difference between the average return on the capital market and the risk-free rate of return. This difference is called the risk premium, since it represents the extra return required for investing in risky assets rather than investing in risk-free assets.

BETA
Beta is an indirect measure which compares the systematic risk associated with a company’s shares with the systematic risk of the capital market as a whole. If the beta value of a company’s shares is 1, the systematic risk associated with the shares is the same as the systematic risk of the capital market as a whole.
Beta can also be described as ‘an index of responsiveness of the returns on a company’s shares compared to the returns on the market as a whole’. For example, if a share has a beta value of 1, the return on the share will increase by 10% if the return on the capital market as a whole increases by 10%. If a share has a beta value of 0.5, the return on the share will increase by 5% if the return on the capital market increases by 10%, and so on.

Numerical 2
Calculating the Required Return using the CAPM Although the concepts of the CAPM can appear complex, the application of the model is straightforward. Consider the following information:
Risk-free rate of return = 4% Equity risk premium = 5% Beta value of RD Co = 1.2
Solution:
Using the CAPM:
E(ri) = Rf + βi (E(rm) - Rf) = 4 + (1.2 x 5) = 10%
The CAPM predicts that the cost of equity of RD Co is 10%. The same answer would have been found if the information had given the return on the market as 9%, rather than giving the equity risk premium as 5%.

Numerical 3
Consider the following information and find the Risk Free Rate of Return
Marker Rate of return = 9%
Required Rate of Return = 10%
Beta value of RD Co = 1.2
Solution:
Using the CAPM:
E(ri) = Rf + βi (E(rm) - Rf)
10 = Rf + 1.2 (9-Rf )
10 = Rf +10.8 -1.2 Rf
.2 Rf = .8
Rf = .8/.2 = 4%

Numerical 4
Consider the following information and find the Return in the Market
Required Rate of Return = 12%
Risk Free Return = 6%
Beta value of RD Co = 1.2
Solution:
Using the CAPM:
E(ri) = Rf + βi (E(rm) - Rf)
12 = 6 + 1.2 (E (rm)-6)
12-6 = 1.2 E (rm) – 7.2
6 + 7.2 = 1.2 E(rm)
E (rm) = 13.2/1.2 = 11%

ASSET BETAS, EQUITY BETAS, AND DEBT BETAS
The asset beta we calculated above assumed that there is no debt. The actual asset beta formula is as follows:

If a company has no debt, its equity beta is the same as its asset beta. Note from the formula that if Vd is zero because a company has no debt, then βa = βe, as stated earlier.
When a company takes on debt, it’s gearing increases and financial risk is added to its business risk. The ordinary shareholders of the company face an increasing level of risk as gearing increases and the return they require from the company increases to compensate for the increasing risk. This means that the beta of the company’s shares, called the equity beta, increases as gearing increases.

Numerical5
Calculate the asset beta of a company. You have the following information relating to RD Co:
Equity beta of RD Co (Be) = 1.2
Debt beta of RD Co (Bd) = 0.1
Market value of shares of RD Co (Ve) = $6m
Market value of debt of RD Co (Vd) = $1.5m
Company profit tax rate (T) = 25%
After tax market value of company = 6 + (1.5 x 0.75) = $7.125m
β a = [(1.2 x 6)/7.125] + [(0.1 x 1.5 x 0.75)/7.125] = 1.024

Numerical6
Calculate the asset beta of a company. You have the following information relating to RD Co:
Equity beta of RD Co (Be) = 1.5
Debt beta of RD Co (Bd) = 0.2
Market value of shares of RD Co (Ve) = $6m
Market value of debt of RD Co (Vd) = $1.5m
Company profit tax rate (T) = 25%
After tax market value of company = 6 + (1.5 x 0.75) = $7.125m
β a = [(1.5 x 6)/7.125] + [(0.2 x 1.5 x 0.75)/7.125] = 1.294

Numerical7
Calculate the Debt beta of a company. You have the following information relating to RD Co:
Equity beta of RD Co (Be) = 1.5
Asset Beta Co (Ba) = 1.3
Market value of shares of RD Co (Ve) = $6m
Market value of debt of RD Co (Vd) = $1.5m
Company profit tax rate (T) = 25%
After tax market value of company = 6 + (1.5 x 0.75) = $7.125m
1.3 = [(1.5 x 6)/7.125] + [(Bdx1.5 x 0.75)/7.125]
Bd = 0 .253.

Counter Cyclic Capital Buffers
Counter Cyclical Capital Buffers (CCCB) are the Buffers which are maintained in opposition to the cycle of the credit growth cycles. In good times bank saves money in the CCCB and in tough times bank takes out money from CCCB and lend it to the outside world. They are a mechanism of Risk Management The aim of the Countercyclical Capital Buffer (CCCB) regime is twofold
1. Firstly, it requires banks to build up a buffer of capital in good times which may be used to maintain flow of credit to the real sector in difficult times.
2. Secondly, it achieves the broader macro-prudential goal of restricting the banking sector from indiscriminate lending in the periods of excess credit growth that have often been associated with the building up of system-wide risk The CCCB may be maintained in the form of Common Equity Tier 1 (CET 1) capital or other fully loss absorbing capital only, and the amount of the CCCB may vary from 0 to 2.5% of total risk weighted assets (RWA) of the banks.